Gross Domestic Product (GDP)

GDP is defined as the market value of all final goods and services produced domestically in a single year and is the single most important measure of macroeconomic performance. A related measure of the economy’s total output product is gross national product (GNP), which is the market value of all final goods and services produced by a nation in a single year.

GDP or GNP? The difference between GDP and GNP is rather technical. GDP includes only goods and services produced by a nation’s own citizens and firms. Goods and services produced outside a nation’s boundaries by the nation’s own citizens and firms are included in GNP but are excluded from GDP. Goods and services produced within a nation’s boundaries by foreign citizens and firms are excluded from GNP but are included in GDP. Typically, there is not much difference in the reported values of GDP and GNP; so one may use either statistic to measure overall macroeconomic activity. The rest of this section will therefore focus on GDP.

Measuring GDP: the expenditure and income approaches. There are two ways of measuring GDP, the expenditure approach and the income approach. The expenditure approach is to add up the market value of all domestic expenditures made on final goods and services in a single year. Final goods and services are goods and services that have been purchased for final use or goods and services that will not be resold or used in production within the year. Intermediate goods and services, which are used in the production of final goods and services, are not included in the expenditure approach to GDP because expenditures on intermediate goods and services are included in the market value of expenditures made on final goods and services. Including expenditures on both intermediate and final goods and services would lead to double counting and an exaggeration of the true market value of GDP.

Total expenditure on final goods and services is broken down into four large expenditure categories, according to the type of good or service purchased. The sum total of these four expenditure categories equals GDP. These four expenditure categories are

Consumption expenditures: Personal consumption expenditures on goods and services comprise the largest share of total expenditure. Consumption good expenditures include purchases of nondurable goods, such as food and clothing, and purchases of durable goods, such as appliances and automobiles. Consumption service expenditures include purchases of all kinds of personal services, including those provided by barbers, doctors, lawyers, and mechanics.

Investment expenditures: Investment expenditures can be divided into two categories: expenditures on fixed investment goods and inventory investment. Fixed investment goods are those that are useful over a long period of time. Expenditures on fixed investment goods include purchases of new equipment, factories, and other nonresidential housing as well as purchases of new residential housing. Also included in fixed investment expenditures is the cost of replacing existing investment goods that have become worn out or obsolete. The market value of all investment goods that must be replaced in a single year is referred to as the depreciation for that year. Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year. The year‐to‐year change in the market value of firms' inventory goods is considered an investment expenditure because these inventory goods will eventually yield a flow of consumption or production services.

Government expenditures: Government expenditures on consumption and investment goods and services are treated as a separate category in the expenditure approach to GDP. Examples of government expenditures include the hiring of civil servants and military personnel and the construction of roads and public buildings. Social security, welfare, and other transfer payments are not included in government expenditures. Recipients of transfer payments do not provide any current goods or services in exchanges for these payments. Hence, government expenditures on transfer payments do not involve the purchase of any new goods or services and are therefore excluded from the calculation of government expenditures.

Net exports: Exports are goods and services produced domestically but sold to foreigners, while imports are goods and services produced by foreigners but sold domestically. In the expenditure approach to GDP, expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate net exports, which is defined as expenditures on exports minus expenditures on imports, and add the value of net exports to the nation's total expenditures.

The income approach to measuring GDP is to add up all the income earned by households and firms in a single year. The rationale behind the income approach is that total expenditures on final goods and services are eventually received by households and firms in the form of wage, profit, rent, and interest income. Therefore, by adding together wage, profit, rent, and interest income, one should obtain the same value of GDP as is obtained using the expenditure approach.

There are two types of expenditures, however, that are included in the expenditure approach to GDP measurement but do not provide households or firms with any form of income: depreciation expenditures and indirect business taxes. Depreciation expenditures, made to replace existing but deteriorated investment goods, do increase the incomes of those providing the replacement goods, but they also decrease the profit incomes of those purchasing the replacement goods. The result is that aggregate income remains unchanged. Indirect business taxes consist of sales taxes and other excise taxes that firms collect but that are not regarded as a part of firms’ incomes. Consequently, indirect business taxes are not included in the expenditure approach to determining GDP, rather it is included in the income approach.

The difference between the expenditure and income approaches to GDP measurement is illustrated in Figure .

GDP is defined as the total market value of all expenditures made on consumption, investment, government, and net exports in one year. If one subtracts depreciation and indirect business taxes from these expenditures, one arrives at national income, which is the sum of all wage, profit, rent, and interest incomes earned in the same year.

Growth rate of GDP. The value of GDP by itself is not very interesting. What is interesting is the annual growth rate, or year‐to‐year percentage change, in the value of GDP. To calculate the percentage change in a statistic, such as GDP, one needs to know the value of the statistic at two dates in time. Suppose that the value of GDP last year was YL and the value of GDP in the current year is YC. Then, the percentage change, or growth rate, of GDP is given by

This formula is valid for calculating the percentage change in any statistic, not just the percentage change in GDP.

A positive growth rate of GDP implies that the economy is expanding, while a negative growth rate of GDP implies that the economy is contracting. An expanding economy is said to be in a boom, while a contracting economy is said to be in a recession.